This is an issue that I’ve discussed a few times in reader mailbags, but I continue to receive so many questions about it that I think it needs to be thoroughly discussed.
Over and over again in personal finance writing, you’ll find references to investment returns on the order of 10% to 12% per year (and sometimes even higher).
Over and over again in his books, Dave Ramsey makes statements like “Invest the $200 difference each month at 10 percent for the next seven years of the car loan. That $200 a month will grow over those seven years into $24,190.” (from The Total Money Makeover Workbook, emphasis added).
Entire books, such as Millionaire By Thirty by Douglas, Emron, and Aaron Andrew, proudly proclaim that rates of return as high as 15% are not only possible but probable over the long haul.
These are just two examples among many. The reason is that there’s a lot of reward in suggesting amazing stock market returns. It makes your financial plan, whatever it might be, look brilliant. You can suggest almost any old ludicrous thing, but if you’re eventually putting it into an investment that returns 12% a year for a significant period, well, your “plan” turns people into millionaires like it’s nothing!
Too bad it doesn’t really work that way.
Over the last decade, the stock market (as estimated by the S&P 500, an index of 500 stocks) has returned about 3% annually. It’s not been the best decade, with two strong downturns in it (2001-2002 and the almost apocalyptic 2008), but it’s an extreme far cry from 12%.
The housing market was producing returns of around 15% per year for the first part of the past decade. The last part? More on the order of -15% per year.
If there’s anyone I’d trust to make long-term calls on the stock market, it’s Warren Buffett. In his own words: “I would expect now to see long-term returns run somewhat higher, in the neighborhood of 7% after costs.”
Here’s the truth. You can sometimes stumble on investments that return 10-12% – or even better – for a few years. Eventually, however, there’s a correction. Speculators get out. People head for the hills. The reason is that the investment becomes overpriced.
(Warning: economic theory approaching. If you’re uninterested, skip this paragraph.) Things increase in value because it produces more than it once did. Most of the time, this is due to an increase in productivity. According to an awful lot of metrics and studies, human productivity does increase over time, but it doesn’t increase annually at a rate of more than 7%. If anything, it increases at a slower rate. (Productivity is difficult to accurately measure.) If you add productivity and inflation together in a very stable economy, you’re probably getting somewhere close to 7%, maybe a bit higher. In other words, the natural value of something fueled by human ingenuity’s actual value increases at a rate less than 7%. When something begins to gain value at a faster rate than that, you’re witnessing a bubble in action. There are speculators involved and, by the time you’ve heard about it, the speculators are usually itching to take a profit.
Add all of these factors together and I think Buffett’s long term prognosis is accurate. I would use 7% annual returns as my long term estimate for an investment with the risk level of the stock market. You might be able to beat that annual return over a short period due to luck, but volatility will eventually eat that return up. You might even be able to beat it over the long term, but you’re taking a lot of risk to do that.
Because of this, I’ve recently started sticking to 7% annual returns for my long-term financial estimation. I calculate a 7% annual return on my retirement portfolio for a long while, eventually going down to about 4% as I move it into secure stuff at retirement age. I use a 7% annual return for every bit of long term savings. I use less than that for short term savings, usually basing that on my current savings account rate, with the advantage that short term savings is essentially riskless. I would suggest you use similar estimates in your long term calculations and be very wary of people proclaiming plans with much higher returns involved.